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Has Eight Ball Slipped Into the 'Side Pocket'?

More Hedge Funds Use Accounts That Restrict Access of Clients, Provoking Concerns Over Returns

November 7, 2005; Page C1

Hedge funds, already the money-management industry's most opaque corner, increasingly are adding extra layers of secrecy to their operations by putting some investments in separate accounts that restrict clients' access to their money and may be susceptible to chicanery.

Known as "side pockets," the accounts are meant to address a glaring conflict. To boost returns, more and more hedge funds are delving into private-equity investments -- shares of nonpublic companies, real estate and the like. Unlike stocks, these investments don't trade continuously on public exchanges, so it is hard to estimate their true value from month to month, quarter to quarter or even year to year, the cycles that hedge funds use to calculate gains.

Managers generally get a cut of a fund's reported gains, making it tempting to inflate the value of these holdings. The Securities and Exchange Commission in the past year has accused several hedge funds of doing just that with some investments, including a few companies that went bust after the dot-com bubble burst.

To mitigate such problems, more hedge funds -- lightly regulated investing pools for wealthy individuals, pension funds and other institutions -- are putting such investments into side pockets excluded from the periodic value calculations. The tactic's proliferation was the talk of an industry conference sponsored by the New York Society of Security Analysts last week.

Here's how it usually works: Say you invest $1 million in a $100 million hedge fund called Big Bucks. It has 75% of its money, including $750,000 of your $1 million, in plain-vanilla investments -- stocks, bonds, options and the like -- and every month Big Bucks calculates their value and keeps the industry standard 20% cut of the gains for itself.

Big Bucks has the remaining 25% of its money in private equity, perhaps some biotech companies that it hopes to sell some day for a big profit. That $25 million, including your remaining $250,000, goes into a side pocket. Under your investment agreement, you can't withdraw any of that money until Big Bucks cashes out some or all of the side pocket's investments, which can take years.

It's like a "mini private-equity fund within a hedge fund," says Woodrow Campbell of Debevoise & Plimpton LLP, a New York law firm that represents hedge funds. The set-up has an obvious advantage: Big Bucks can't pump up its monthly cut by artificially boosting the side-pocket investments' value. The true value -- and Big Bucks' cut -- is determined by the actual sale of the holding, perhaps through an initial public offering of stock.

But restricted access to the money is just one downside. Side pockets give hedge funds other ways to cheat, in part because managers often don't tell investors how those holdings are doing on a regular basis. "You never know what's going on in that side pocket," says Joseph Omansky, founder of Sky Fund, an East Brunswick, N.J., research firm. Side pockets can "create the potential for more fraud and additional risk in the industry."

The biggest risk: A hedge fund could exile poor investments into a side pocket, allowing the fund to post jazzy returns on its stronger-performing investments, while keeping sour deals in a black hole. If the side-pocket investments later are sold at a loss, investors take the hit -- without dinging managers' performance fees.

"The danger is, if they're putting their dogs in that side pocket, it's leading to their performance results being misrepresented," says Steven Caruso, a partner at Maddox Hargett & Caruso, a New York law firm.

Hedge funds use other methods to address the conflict involved in valuing private investments, but these aren't perfect either. Some hire an independent valuation firm to make estimates, but that can be cost-prohibitive for smaller funds. Others establish internal audit committees to double-check estimates, but those committees depend on information from fund managers.

Side pockets aren't new. They've been used since the 1990s for private investments. After the 1998 collapse of Long-Term Capital Management, a huge hedge fund, managers began using them as junkyards for bad investments they couldn't unload -- illiquid, in industry parlance -- industry insiders say. "In the event of a market freeze-up...there's an ability to use those side pockets for investments that have turned illiquid," says Bill Natbony, a partner at the Chicago law firm Katten Muchin Rosenman.

Some hedge-fund agreements allow money to be put into side pockets at any time, and managers use that power to block investors from withdrawing money from funds that hit rocky patches. Kevin Campbell, vice president at Van Hedge Fund Advisers, cites a recent example involving a hedge fund he tracks: Some clients of the fund, which invests in biotech outfits, asked for their money back. The withdrawals would have forced managers to sell some of the fund's small-company holdings immediately for a loss, so the fund instead put the holdings in a side pocket in hopes of selling them for a better price later.

"It was done to save the investors from themselves," Mr. Campbell says.

David Nichols, a hedge-fund attorney with New York-based Morgan Lewis & Bockius, says such moves can seem legally murky, but notes that investment agreements often give managers lots of leeway in using side pockets. "The partnership agreements are very broadly drafted on points of these kinds," he says.

Hedge funds with side pockets typically agree to limit how much the fund can divert into them to between 10% and 30% of their holdings. Broadfield Capital Management, a Morristown, N.J., hedge fund with $30 million under management, set aside 30% of its assets for side-pocket investments. About a third of that $9 million is tied up in Integro Ltd., a New York insurance-brokerage firm, and the rest is waiting for better opportunities, says Jefferson Kirby, the fund's manager.

Eric Mindich, the former Goldman Sachs investment whiz who caused a stir last year by starting a $3 billion hedge fund called Eton Park Capital Management, also allocated up to 30% toward side-pocket investments.

Unless hedge-fund agreements have strict continuing limits, investors risk having disproportionately big shares of their investments tied up in private equities that can't be easily cashed out. Investors who agree to have a relatively small percentage of their initial investment in side-pocket investments would see that percentage balloon over time if those investments grow while the other investments do poorly.

Side pockets aren't used only for private investments. Activist hedge funds that specialize in taking large positions in public companies to pressure management for shareholder-friendly changes use side pockets to prevent withdrawals that would cause them to diminish their stake in -- and influence over -- a target company.

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You never know what's going on in that side pocket, says Joseph Omansky, founder of Sky Fund, an East Brunswick, N.J., research firm.

Side pockets can create the potential for more fraud and additional risk in the industry.

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